Sunday, November 23, 2014

Quantitative Quicksand

PITTSBURGH – Almost all recoveries from recession have included rapid employment growth – until now. Though advanced-country central banks have pursued expansionary monetary policy in the wake of the global economic crisis in an effort to boost demand, job creation has lagged. As a result, workers, increasingly convinced that they will be unable to find employment for a sustained period, are leaving the labor force in droves.

Nowhere is this phenomenon more pronounced than in the United States, where the Federal Reserve has reduced interest rates to unprecedented levels and, through quantitative easing (QE), augmented bank reserves by purchasing financial assets. But inflation – which rapid money-supply expansion inevitably fuels – has so far remained subdued, at roughly 2%, because banks are not using their swelling reserves to expand credit and increase liquidity. While this is keeping price volatility in check, it is also hindering employment growth.

Rather than changing its approach, however, the Fed has responded to slow employment growth by launching additional rounds of QE. Apparently, its rationale is that if expanding reserves by more than $2 trillion has not produced the desired results, adding $85 billion more monthly – another $1 trillion this year – might do the trick.

America’s central bankers need not search far to find out why QE is not working; evidence is published regularly for anyone to see. During QE2 (from November 2010 to July 2011), the Fed added a total of $557.9 billion to reserves, and excess reserves grew by $546.5 billion. That means that banks circulated only 2% of QE2’s contribution, leaving the rest idle. Similarly, since QE3 was launched last September, total bank reserves have grown by $244.1 billion, and excess reserves by $239.4 billion – meaning that 99% of the funds remain idle.

Given that banks earn 0.25% in interest on their reserve accounts, but pay very low – indeed, near-zero – interest to their depositors, they might choose to leave the money idle, drawing risk-free interest, rather than circulate it through the economy. At current interest rates, banks lend to the government, large stable corporations, and commercial real-estate dealers; they do not extend credit to riskier borrowers, like start-up companies or first-time home buyers. While speculators and bankers profit from the decline in interest rates that accompanies the Fed’s asset purchases, the intended monetary and credit stimulus is absent.

At some point, the Fed must realize that its current policy is not working. But developing a more effective alternative requires an understanding of the US economy’s actual problems – something that the Fed also seems to lack. Indeed, Fed Chairman Ben Bernanke often says that his goal is to prevent another Great Depression, even though the Fed addressed that risk effectively in 2008.

The US economy has not responded to the Fed’s monetary expansion, because America’s biggest problems are not liquidity problems. As every economics student learns early on, monetary policy cannot fix problems in the real economy; only policy changes affecting the real economy can. The Fed should relearn that lesson.

One major problem, insufficient investment, is rooted in President Barack Obama’s effort to increase the tax paid by those whose annual incomes exceed $250,000 and, more recently, in his proposal to cap retirement entitlements. While such proposals have been met with opposition, Obama cannot be expected to sign a deficit-reduction bill that does not include more revenue. As long as that revenue’s sources, and the future effects of new regulations, remain uncertain, those whom the policies would most harm – the country’s largest savers – are unlikely to invest.

Likewise, Obama’s health-care reform, the Affordable Care Act, has hampered employment growth, as businesses reduce their hiring and cut workers’ hours to shelter themselves from increased labor costs (estimates of the rise vary). Meanwhile, the faltering European economy and slowing GDP growth in China and elsewhere are impeding export demand.

While subdued liquidity and credit growth are delaying the inflationary impact of the Fed’s determination to expand banks’ already-massive reserves, America cannot escape inflation forever. The reserves that the Fed – and almost all other major central banks – are building will eventually be used.

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    1. CommentedParrain Boursorama

      I agree with much in White’s analysis. As he stresses, the most fundamental driver of financial instability is the ability of fractional reserve banks (and shadow banking systems) to create credit and money, and thus to inject additional spending power into the economy.

    2. CommentedJames T Marsh

      As near as I can tell, in today's post Prof Meltzer is confirming that those predictions he made four and five years ago about QE resulting in inflation were wrong because banks kept the proceeds as excess reserves. This is exactly what was predicted by those who Meltzer was lambasting at the time for the very reason he now gives! It's a classic Keynesian liquidity trap.

      Now I am all for revising predictions and even changing positions when new data or new knowledge become available. But to be predicting dire inflation as the result of QE when the banking system's appetite for liquidity appears almost infinite is a classic case of doubling down on dumb.

      When banks start lending instead of holding excess deposits will be the time to throttle back QE. The Fed's big mistake lately has been to signal this change too early and ignite a bond sell-off.

    3. CommentedFrank Hollenbeck

      The article to a large degree restates the obvious. The definition of insanity is to continue doing the same thing and expecting different results. We do not have a demand problem. We never have a demand problem. the concept of aggregate demand is the poison eating at the heart of the economic profession. We have a supply problem, and the best the government could do is get out of the way, implement policies that worked before, like in 1920 or in Latvia in 2009-2010. Cut spending 50% and taxes 35%. Free up resources and allow the price system to do its job, allocating resources where they are most needed.

    4. CommentedAlex Imas

      If memory serves me right, private sector investment is NOT the drag on the US economy. It's actually mostly government spending, along with consumption. It might be a good idea for Professor Meltzer to proceed from facts to conclusions instead of starting with the conclusion (taxes/Obamacare did it) and making up the facts to go along.

    5. CommentedJose araujo

      Amazing the ability to present the arguments and then draw incredible conclusions.

      So QE isn't working because banks are not circulating money, but instead of arguing in favor of direct fiscal policies, you argue against QE...

      QE always produces inflation, but now we have no inflation, and Mr. Meltzer conclusion is..... NONE... maybe he should review his theories and include the notion of liquidity traps, and that we don't always live in full employment, and that public investment crowd-out with unemployment is a MYTH

    6. CommentedRobert Lunn

      Dr. Meltzer can't get Obama off his mind sadly. Listening to him throughout this period he continues to frame this recent crisis as if its a cyclical downturn.
      How many times do we have to hear Bernanke at the HH testimony say that monetary policy alone can't solve the current problems? One thing about the Fed, like it or not, Ben has been transparent. he has discussed sterilized plans emphasizing and focusing on participants being able to borrow short and loan long with impunity. The Fed has promoted the notion of short term fiscal stimulus with a strong plan for long term deficit reduction. Dr. Meltzer may not like it and it may indeed be foolish to believe our politics would allow counter cyclical government actions if times ever got better.
      The folks Dr. Meltzer seems concerned about; "job creators" have not been treated better in my time. Just look at where the income generated is ending up. Maybe he should look at the period from the Bush tax cuts forward or go further back for evidence of this correlation and put it out there.
      This is a great economist who should take some of the advice he is giving to the Fed and examine his approach, which has not been right for some time.

    7. CommentedKaimu Biz

      Aloha! What concerns me most about QE or practically any other Fed policy is that it is short sighted and corrupt. In the words of economist Steven Keen, down under ... WE BUILT NO HOOVER DAMS THIS TIME! True enough, but we did save Fannie and Freddie and Merrill and AIG. What ultimately do the masses get out of this FED SPREE of $85BIL monthly? Inflation adjusted Hoover Dam would cost some $2.8BIL to build today. That works out to be 30 Hoover Dams that the US FED expends monthly! When the Fed exits will we then get any Hoover Dams? Quicksand indeed ...

    8. CommentedZain S.

      The Fed is not out of options. They should allow for modest inflation by raising the inflation target to 3%-4%. Higher expected inflation over the medium-run will persuade investors and businesses to invest right-now.

        CommentedZain S.

        Also, it's not banks sitting on reserves, but rather businesses and investors sitting on cash that is leading to a shortfall in private investment.

    9. CommentedRock Steady

      The Fed can't do it all by itself; it needs Congress and the President to step up with pro-growth fiscal policy. Instead, all we have gotten is fiscal austerity and debt hysteria. So, yes, quantitative easing and monetary policy are becoming less effective with each round, and the exit from QE might bring volatility in asset prices, but that does not mean the Fed should stop. Until we this depression is over, the Fed needs to do all it can. I find this piece unconvincing and misleading.

    10. Commentedezra abrams

      Regarding the idea that Obama's proposed increase in taxs on those making >250k is reducing investment
      1) why didn't this hurt in the past 50 years ?
      2) afaik, recalling data from brad delongs site, investment in the post 2008 era has been pretty robust, except for the gov't sector
      3) I happen to live in a wealthy town, on a wealthy street. judging by the huge, vast, enormous sums being spent on home remodeling, there is no shortage whatsoever of capital
      4) I happen to work in the biotech sector; the shortage is not capital, but good ideas

    11. Portrait of Eduardo Moron

      CommentedEduardo Moron

      If you calculate the ratio of commercial bank loans to total assets held by those banks we are at a 40 year minimun. Banks are too scared to loan, households are unwilling to ask for more loans as they are still deleveraging.

    12. CommentedProcyon Mukherjee

      It seems there is a disconnect between borrowers and savers and that too much liquidity has tilted the balance.

      I am sorry that I am caught between the urge to understand and to respond as I go through the motions of reflecting on what I gather as one of the least cultivated subjects of our time, while being the most visible one in the blogosphere.

      I have this nagging doubt that sometimes tilts towards a disbelief of the fractional reserve system and its purpose as it stands today; or for that matter money itself, as it mistakenly replaces capital, and in its over-abundance we find the scarcity of ideas in building a meaningful foundation of an economy that does not falter from one day to the other following cues, or simply an information over-drive that masquerades the true underlying facts.
      Money must move between savers and borrowers and the exchange must have a purpose that satisfies an economic need; the fractional reserve system, together with the Central bank engineering initiatives cannot replace the basic structure of lending that leaves one section completely neglected at the cost of the other. Is it possible to have only borrowers (going by the incentives for the same) and no incentives for savers in an economy? Could we therefore sufficiently posit for making people to spend and consume?

    13. CommentedGary Foxwell

      Why do these economist keep insisting that the rich are not investing because of the fear of higher taxes or health care cost. If we can generate some inflation the rich will invest, because the bags of money they are setting on will start to lose value and they will be forced to spend some of it. Corporations make spending decisions based on sales first and tax considerations second. No sales no spending.

    14. CommentedJohnny (MoneyWonk)

      Allan: Bernanke has said many times that his preferred tool for preventing the excess reserves from flooding the system too fast is raising the interest rate paid on excess reserves. This should prevent inflation from getting out of control. However, this begs the question: why isn't he using this tool in order to get those reserves out when, as you said, 99% of the QE pumped isn't going out into the real economy. Bringing it down to zero or negative territory - like Sweden and other Central Banks have tried before - would make current monetary policy more effective at the Zero Lower Bound.

    15. CommentedJake Lopata

      It seems to me that the general consensus among economists is that you need BOTH monetary and fiscal policy. Since the Federal Reserve is the only institution doing anything about the recession, I suppose it's easier to criticize their methods.

      Where is Congress?

    16. CommentedG. A. Pakela

      You're too conservative, Dr. Melzer, to be taken seriously. All of your peers, like J. Bradford DeLong, know that you don't really care about employment. You are only a shill for "the rich," even though your policy precriptions are spot on correct and would result increased employment throughout "flyover country." GA Pakela, Hnz '82

    17. CommentedCraig Hardt

      You started off well in describing what can kindly be called an extraordinarily inefficient way of stimulating demand through QE. I'm disappointed that you didn't offer any solutions to this inefficient mechanism. The Fed can't change fundamentals in the economy but it's obvious that the politicians in charge of fiscal policy can't either. Given this reality, what should the Fed do? Throw in the towel and hope for the best?

        CommentedRobert Lunn

        Mr. Heller-just exactly when have the wealthy or corporations done better than they are doing now?

        Portrait of Michael Heller

        CommentedMichael Heller

        Craig, Allan Meltzer does offer the alternative here, but it’s implicit and hardly involves the Fed at all because instead of or in addition to monetary policy he's suggesting “policies for the real economy”, which above all are the policies to get the existing pools of money (currently ‘sensibly saved’ or ‘selfishly hoarded’ depending on your viewpoint) moving through the economy into investment, i.e. policy positions that are market-friendly, predictable, permanent and non-discretionary in order that investors, savers, tax payers will believe they remain true-for-the-future. The two books naturally are Meltzer’s own ‘Why Capitalism’, and also John B. Taylor’s ‘First Principles’.